Which Option Strike Price Should I Trade?

Posted by Pete Stolcers on February 13

Option Trading Question

Can you blog about the strategies that you use to pick the option strike price and expiration month once you have identified a possible stock? Also are there any tools out there one can use to identify possible profit and loss and probability of success for option trading?

Option Trading Answer

Throughout my blog you will find that your option strategy is a function of your opinion. You have to nail down the direction, duration and magnitude of the move. Then you need to assess your confidence in; the market, your analysis and your recent performance. All of these factors will lead you to the optimal strategy and trade size.

If I have a long term grinding move in a stable stock and the market is neutral, I would probably opt for an ITM call that has a few months of life. I will be buying intrinsic value and the option will move point for point with the underlying. This gives me the latitude to take profits along the way. This is almost like a surrogate stock position.

If I am looking for an explosive move in a short period of time, I will buy a front month OTM option. That will give me the biggest bang for my buck and I can buy more contracts.

If I am fairly confident in the stock’s strength, but the market is volatile (like now), I might consider selling an OTM put credit spread. This strategy will give me more cushion. If the market moves against me, the stock should hold up well and the puts will expire. If the market falls apart I should have time to buy back my put spread before things get ugly.

I trade relative strength and weakness within the market - that is my edge.

As for software, OptionVue has very good scenario analysis software. It will calculate your P&L based on many different outcomes. For most traders, this software is overkill. I like to keep things simple.

Know your stop before you place the trade. If your forecast was wrong, get out. When a trade is profitable, start getting out when the move stalls. Predetermined targets will often leave too much money on the table and you need to let your winners run as long as they are behaving.

Option Trading Comments

On 03/07, BounFor Hell said:
The trades that worked for me in the past I traded close to the In The Money Option chains. The further out the expiry date better, but I often settle for one to three months.

If you pick the one-month option chain then you better be sure that the trend and market trend are going hand in hand. Common sense dictates that you cannot short in a bull market unless there had been some material change in the company. Always trade with the market because it’s a well know fact that at least 70% of the stocks follow the market trend.

One month or less options are not for the faint of heart, but if they go your way you will get richly rewarded.

Two, three and four month out expiry date options are a lot better because change comes slowly and you have time to get out if the trade did not go your way. Two to three month options close to the In the Money Option chain are the way to go.

Example:
Stock XWZ is currently in a downward trend, the market ( DOW, TSX,) or whatever market you are trading is also in a bear trend. The stock is at $19.50, the next available chain that is out of the money for PUTs is $17.50 that would be the chain that I would consider buying. Now you need to decide which chain will give you the best bang for you initial outlay >>> two, three or even four months out expiry dates. They are differences in the delta and liquidity in each chain. I tend to pick the chain with the most liquidity and also look for the BID and ASK spread to be close together.

Because this worked for me in the past, I now try to abide by the above game play.

Good Trading
BoundForHell
On 03/08, Mladen Nadj said:
Whay Options are not traded at extended and pre market hours.
Are options prices adjusted automaticly on opening of the market acording to stock move in premarket trading?
On 03/18, Options View said:
First of all this is one of the best blogs on the options market on the web.

I trade options in emerging markets and things work bit differently. This market provides good opportunity to make easy money selling far OTM even when it is few days left to expiry as you will always find buyers.

I look at my trading strategy from combination of time decay and volatility point of view. Many investors in Asia look at the option price price perspective - a 30$ ITM is always expensive options compared to 2$ OTM with high I vols.

visit my blog:

http://www.optionsview.blogspot.com

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